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FASB moves forward with new model for financial instrument impairment

FASB’s new model for impairment of financial instruments is clearing
hurdles as the board pursues a different path than its international
counterpart on expected credit loss.

The revised credit impairment model FASB is developing will be
re-exposed separately from tentative proposals on the classification
and measurement of financial instruments, according to a summary of tentative
board decisions posted on FASB’s website. Tentative FASB
decisions can be changed at future board meetings and are included in
an exposure draft only after a formal written ballot.

The board has continued to move forward with the “Current Expected
Credit Loss” (CECL) model it has been developing separately from the
International Accounting Standards Board (IASB) since July.

In a project that has been pursued jointly with the IASB, FASB in
July decided to take a step back from the so-called “three-bucket”
impairment model the boards had been developing for financial instruments.

Addressing concerns from stakeholders, FASB has been working
separately from the IASB to develop the CECL model for
impairment. Stakeholders had been concerned about the
understandability, operability, and auditability of the three-bucket
model, as well as whether it would measure risk appropriately.

The CECL model retains the three-bucket model’s main concept of
expected credit loss, and the current recognition of the effects of
credit deterioration on collectibility expectations.

But the CECL model uses a single measurement objective—current
estimate of expected credit losses—rather than the dual-measurement
approach used in the three-bucket model. The dual-measurement approach
requires a “transfer notion” to differentiate between financial assets
that are required to use a credit impairment measurement objective of
“12 months of expected credit losses” and those that are required to
use a credit impairment measurement objective of “lifetime expected
credit losses.”

The CECL model would require that at each reporting date, an entity
would reflect a credit impairment allowance for its current estimate
of the expected credit losses on financial assets held. The estimate
of expected credit losses would reflect management’s estimate of the
contractual cash flows that the entity does not expect to collect and
is neither a best case nor a worst case scenario.

This week, FASB tentatively decided to move forward with the CECL
model without broadly considering the accounting for modifications.
The CECL model would apply to all modified instruments where expected
credit losses are based on the expected shortfall in contractual cash
flows and discounted using the effective interest rate post-modification.

To accomplish this, the guidance in ASC Subtopic 310-40 would be
amended. The amendment would require that when a troubled debt
restructuring is executed, the cost basis of the asset should be
adjusted so that the effective interest rate after modification is the
same as the original effective interest rate, given the new series of
contractual cash flows.

The basis adjustment would be calculated as the amortized cost basis
before modification less the present value of the modified contractual
cash flows, discounted at the original effective interest rate.

FASB tentatively decided that a cumulative-effect approach would be
used as a transition method for the CECL model. A cumulative-effect
adjustment would be recorded on an entity’s statement of financial
position as of the beginning of the first reporting period in which
the guidance is effective.

The IASB has been monitoring FASB’s credit loss model discussions
but has not pulled back from its commitment to the three-bucket model.
At next week’s meeting, the IASB staff plans to provide the IASB with
feedback from stakeholders related to the operational aspects of the
proposed impairment model.

Both boards have targeted the fourth quarter of this year for EDs on
impairment of financial instruments.

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